Excerpts from Craig Donohue's Statement to the Joint CFTC-SEC Committee on June 22 , 2010
Since May 6, 2010, CME Group has engaged in a detailed analysis regarding trading activity in its markets on that day. Our review indicates that our markets functioned properly. We have identified no trading activity that appeared to be erroneous or that caused the break in the cash equity markets during this period. Moreover, no market participant in our markets reported that trades were executed in error nor did the CME Exchanges cancel ("bust") or re-price any transactions as a result of the activity on May 6th. Moreover, the CME markets provided an important price discovery and risk transfer function on that day and served as a moderating influence on the markets.
The CME markets functioned properly on May 6, 2010
a. CME has conducted a review of detailed trading records
CME Group analyzed trading volume and activity throughout May 6 and focused particularly on the activity taking place during the period of 1pm to 2pm Central Time. Total volume in the June E-mini S&P futures on May 6 was 5.7 million contracts, with approximately 1.6 million or 28% transacted during the period from 1pm to 2pm Central Time. During that hour, the market traded in a range of 1143.75 to 1056, or 87.75 points -beginning the hour at approximately 1142 and ending the hour at approximately 1113. More than 250 CME Globex execution firms, 8,300 accounts and 9,000 User IDs were active in the market during this period of time.
During most of that hour, the bid/ask spread in the E-mini futures was a tick wide (0.25 points) and the market traded in a largely orderly manner despite the significant sell off and subsequent rally. At approximately 1:45:28, the market declined 12.75 points over a period of approximately 500 milliseconds on the sale of 1100 contracts by multiple market participants. The last 6 points of that move occurred in 5 millisecond on the sale of approximately 400 contracts for stop orders. Following those sales, the bid/ask spread widened to 6.5 points, or 26 ticks for a fraction of a millisecond.
At that moment, one of CME Group's risk management functionalities, CME Globex Stop Logic was triggered. As a result, the market was automatically paused for five seconds to allow liquidity to come into the market. The market subsequently reopened three ticks higher at 1056.75, and thereafter rallied more than 40 points to 1097 in the following three minutes.
The Market Regulation Department reviewed a significant amount of activity during this one hour period, a period that included more than 3 million system messages, and, in particular, examined the activity of participants whose trading activity was significant or otherwise warranted further review. The review conducted by Market Regulation staff to date has not identified any evidence of improper or illegal activity by market participants.
b. CME Markets Provided an Important Price Discovery and Risk Transfer Function on May 6
From a broader perspective, the cumulative record of May 6 trading activity underscores the fact that CME's futures markets, due to their high level of liquidity, provided an important price discovery and risk transfer mechanism for all market participants on that day.
The equity index futures contracts traded on CME Group designated contract markets provide an essential risk management function, allowing investors to hedge their exposure against a portfolio of shares or equity options. The most significant equity index futures contract traded on the CME Group Exchanges is the E-mini S&P 500 futures contract. In 2009, the E-mini contract traded over 556 million contracts, which represents an average daily volume in excess of 2.2 million contracts, making the E-mini S&P futures contract the most liquid equity index futures contract worldwide. Throughout the challenging market conditions on May 6th, market participants utilized the liquidity and efficiency of the E-mini S&P 500 futures contracts to meet their risk management needs; the contract effectively facilitated customer demand to hedge exposure to a declining broader market and, as will be shown below, represented a moderating factor during the day's trading session.
The primary purposes of futures markets are to provide efficient price discovery and an effective risk management mechanism. In particular, the academic literature underscores the efficacy of futures markets as a tool of price discovery.
Futures contracts, by design, provide an indication of the market's view of the value of the underlying stock index. Casual observation may lead to the conclusion that the E-mini S&P futures prices appeared to lead the decline in the cash market. However, the decline was consistent with declines in the most complementary equity derivative products, ETFs based on the same index, trading in the cash market. The E-mini S&P moved virtually in tandem with the comparable cash instrument until the moment when our Stop Logic was triggered which caused our matching engine to pause for 5 seconds while continuing to allow new orders to be entered. At the time the Stop Logic was triggered, the E-mini S&P ceased its drop, while certain individual stocks in the cash market continued their steep decline. Following the halt, the E-mini S&P then rallied sharply. We believe this recovery was positively influenced by our Stop Logic functionality which stabilized market activity. This type of functionality is not available in the securities market. Consequently, even while the broad based index markets –SPYs and CME E-mini S&P -were substantially recovering, there were continued price declines in individual stocks which persisted for minutes (not seconds).
More specifically, to illustrate this point, we reviewed the period from 13:30 to 14:00 (CT) during which the market activity occurred. E-mini S&P 500 futures were declining after 13:30 (CT) followed by spot equity markets including Proctor & Gamble (PG), 3M (MMM) and Accenture (ACN). The June 2010 E-mini S&P 500 futures traded at its low of 1,056.00 at 13:45:28 (CT), at which point the Stop Logic functionality was triggered halting the decline, and the market rallied following the 5-second halt. PG, MMM and ACN continued to slide even after futures hit their low and began to recover. Those stocks were put into a reserve mode by the New York Stock Exchange (NYSE) per its Rule 1000(a), Liquidity Replenishment Points, at 13:45:52, 13:50:36, 13:46:10 (CT), respectively; however, these stocks continued to decline. We believe that this decline continued because orders were re-routed to possibly less liquid security trading venues which were not coordinated with NYSE Rule 1000(a). PG printed a low of $39.37 at 13:47:15 (CT); MMM printed a low of $67.98 at 13:45:47 while ACN printed a low of $0.01 at 13:47:54 (CT). Thus, the E-mini S&P 500 futures were rallying while PG, MMM and ACN continued to decline.
As stated above, we believe that this temporary de-linkage between the futures and stock markets may be attributed to inconsistent rules across the equity markets which enabled the stocks to decline even further.
The trading activity during this time period also evidences that the futures markets provided an important source of liquidity which served as a moderating influence in the markets. There is strong evidence that the E-mini S&P futures contract was much more liquid than the fragmented underlying stock market on May 6. During the period between 1:40 and 2:00 CST, the volume of E-mini S&P futures (notionally adjusted) was 3 to 4 times greater than the SPY volume and, at the peak of the market's volatility, was to 8 to 10 times greater.
Circuit Breaker Levels should be Reviewed and Rules Should be Consistent Across Markets.
a. CME Group Circuit Breaker Rules In Effect Were Consistent With Equity Markets
One of the mechanisms that exchanges have implemented to curb market volatility are "circuit breaker" rules. Circuit breaker rules require an automatic halt in trading when pre-determined price thresholds are reached. CME Group Exchanges currently have circuit breaker rules in effect for equity index products which are consistent with the 10%, 20% and 30% market-wide circuit breaker rules in the underlying equity markets. CME Group also implements an unconditional trading halt in an equity index futures contract which the primary stock market is halted, regardless of whether a particular index product has hit a limit or not.
Circuit breaker rules were originally introduced following the September 1987 market crash. The circuit breakers were implemented uniformly across all equities and options exchanges and were set at a fixed price level tied to the DJIA. This rule was embodied in NYSE Rule 80B.
On October 27, 1997, the circuit breakers were triggered for the first time and the circuit breaker rules were subsequently modified to employ percentage declines of 10, 20 and 30% in the DJIA established at the start of each calendar quarter in lieu of the fixed point triggers previously used. That rule remains in effect.
In addition to the coordinated circuit breakers, CME adopted price limit rules for its equity index contracts. The price limit structure and levels changed several times as the Exchange acquired more experience and as the trading halt rules in the equity market were modified.
In January 2008, however, CME harmonized its price limit percentage thresholds to be fully consistent with the percentage thresholds reflected in NYSE Rule 80B (and also consistent with the methodology employed by the CBOT with respect to the DJIA futures). CME Group did, however, retain the references to the specific stock index that is the subject of the futures contract rather than tying these limits to movements in the DJIA, meaning, for example, that the E-mini S&P 500 price limits are tied to price movements in the related index.
On May 6th, the declines in the DJIA were just short of 10% at a time of day when the 20% trigger was in effect. As a result, the circuit breakers in the primary and the futures markets were 5 not triggered. Accordingly, we believe that the current circuit breaker levels of 10,20 and 30 percent, the duration of the halt and the time of day at which such triggers are applicable should be reevaluated to determine whether any changes are warranted.
b. Lack of consistent rules across all markets contributed to market events
After May 6, CME Group staff reviewed the relevant processes and rules across its exchanges and the equities exchanges to determine what protections existed in the operating rules of the various equities platforms in the event of a market disruption. This review confirmed that the equity markets are highly fragmented with disparate rules and functionality, and it appears to us that this lack of consistency across the equity markets likely contributed to or exacerbated the problems experienced on May 6.
For instance, as noted above, we believe that the lack of consistency and coordination among equity platforms in the establishment of circuit breakers for individual stocks led to extreme market disruptions; when the NYSE rule circuit breaker rule was invoked with respect to trading in individual stocks, order flow circumvented the NYSE market and trading continued on other platforms which did not have comparable protections. Consequently, as a result of the lack of liquidity on these other platforms, trading in those individual stocks suffered significantly.
We also note that in the aftermath of the May 6 incident, there was significant confusion in the equity markets with respect to the cancellation or "busting" of trades. The standards for cancellation of trades are not consistent or transparent across the equity markets as a whole. At the CME Group, we have clear standards regarding the handling of error trades, including specified "no bust" ranges for each product (i.e., ranges within which trades may not be cancelled) and these standards are clearly set forth in our rulebook and are posted on our website.
We acknowledge and welcome the recent efforts of the SEC and the equity exchanges to address these issues, including the June 10, 2010 circuit breaker pilot program as well as the June 17 announcement of the proposed implementation of rules surrounding clearly erroneous trades; we believe, however, that further action is necessary in the short term to be fully responsive to the events of May 6. These efforts are essential to ensure the integrity of the market and to promote market confidence among users.
c. Recent Proposals Do Not Fully Address the May 6 Market Events and May Have Unintended Consequences for Index Products and ETFs
We believe that the individual security circuit breakers, without immediate additional action, are not fully responsive to the market events of May 6, and that the industry as a whole must do more as quickly as possible to avoid the negative consequences of the lack of coordination across markets that contributed to the events of May 6. A comprehensive and effective course of action would include the implementation of newly-calibrated and coordinated market-wide circuit breakers as soon as possible. We believe this is the most effective preventative measure to address concerns regarding the type of market-wide volatility witnessed on May 6. Additional necessary action should include prompt elimination of stub quoting practices and the implementation of measures to mitigate the impact of isolated liquidity gaps (or errant order entry) in individual products in ways that will not disrupt the broader market. For example, all orders, including market and stop orders, should have associated limits that preclude orders from being executed at unreasonable levels when there is a temporary absence of liquidity in the market or erroneous entry of an order.
CME Group has risk management controls to mitigate the potential for distribution of its markets
Stop Logic Functionality
The CME Globex system has a Stop Logic functionality which serves to mitigate artificial market spikes that can occur because of the continuous triggering, election and trading of stop orders due to insufficient liquidity. If elected stop orders would result in execution prices that exceed pre-defined thresholds, the market automatically enters a brief reserved state for a predetermined time period, ranging from 5 -20 seconds. During this period, no orders are matched but new orders other than market orders may be entered and orders may be modified and cancelled. The momentary pause that occurs when Stop Logic is triggered allows market participants the opportunity to provide liquidity and allows the market to regain equilibrium, thereby mitigating the potential for disruptive market moves.
High Frequency Trading enhances liquidity
An important issue raised in this discussion is the impact of high frequency traders ("HFTs") on the events of May 6 and their future role in the markets. As recently described in the SEC's Concept release on market structure, high frequency trading was identified as one of the most significant market structure developments in recent years. Although HFT is not clearly defined, "it typically is used to refer to professional traders acting in a proprietary capacity that engage in strategies that generate a large number of trades on a daily basis."
CME Group believes that HFTs play an important role in the markets, particularly when trading is complemented by the types of exchange risk management procedures detailed in the previous section and strong risk management practices at the firm level. HFTs are an important part of daily trading activity in the marketplace and have evolved in response to advancements in technology. This represents the natural evolution of technological advancements and improvements in the marketplace and the percentage of trading volume attributable to HFTs will likely continue to increase in the future. There is evidence that HFTs increase liquidity and transparency in the marketplace and narrow spreads which allows investors to buy and sell securities at better prices and at lower costs.
It is also important to note that not all HFTs are alike and employ a wide variety of different strategies. A significant proportion of HFTs active on the CME Group Exchanges promote liquidity by providing continuous markets in our products. As illustrated by the events of May 6, in analyzing the role of several HFTs, a majority of those entities' trading executed during the relevant one-hour period was related to the firm's market making activities. Thus, before contemplating restrictions on HFT activity, consideration should be given to the beneficial role played by HFTs in providing liquidity during normal market activity as well as during times of increased market stress.
The use of high frequency trading by proprietary trading firms, investment banks, hedge funds and index traders, among others, has made the marketplace more efficient and competitive for all market participants. Careful consideration should be given to any decision to place significant restrictions or limitations on HFTs that would be harmful to the marketplace and result in less efficient and less liquid markets.
As noted previously, CME Group has extensively examined the activity in our markets on May 6, 2010. Based upon our review of the activity, to this point, we believe that there are potential changes which would improve the functioning of the markets, particularly during times of severe stress.
Throughout this process we have continued to work closely with our regulator, the CFTC, as well as with other regulators not only to identify the causes of significant volatility on May 6, but also to assist in providing thoughts and recommendations for market improvement. Of course, as we continue to study the events further, we would be happy to contribute our further thoughts and recommendations.
• Immediate additional action is necessary to address the market events of May 6. A comprehensive, coordinated and quantitative review of the market-wide circuit breaker levels and duration of pause should be undertaken across all market centers and trading venues supporting equity based products, including cash equities, single name and index options, single stock futures, index futures and options on index futures and total return swaps and structured products.
• Stop Logic and other risk mitigation functionality should be adopted across markets. on a product by product basis. As evidenced by the trading activity on May 6, we believe that our Stop Logic functionality provided the opportunity to source needed liquidity at a crucial time and contributed to allowing the market to gain its equilibrium. Additionally, practices such as stub quoting should be promptly eliminated.
• The effect of the newly implemented circuit breakers on individual securities must be examined. The rules implementing individual security circuit breakers create the potential for disruptions in the trading of broad-based market index and index-based products and could compromise the effectiveness of risk management systems. In addition, to the extent that circuit breakers are applied to equity index ETFs, the parameters should be different than those applied to individual stocks and should be consistent with comparable products across markets.